Professional investors and their approach to the quantitative part of an analysis

I have seen many type of quantitative valuation methods in my short investing experience.

Ones that break down CAPEX, EBIT, EBITDA, Tax Rate, R&D etc. each line projected in the future then they compute FCF to Firm, NPV etc. the excel sheet is longer than a PhD thesis.

Others (the ones you find on the net easily) tend to use FCF from Cash Flow with 3 estimates of growth (bear, base and bull cases). They average the 3, discount it by 12%-15% and call it a day.

Then there are those that do DCF, DDM, EPV, NetNet, all kind of valuation Technics and average them all, add 25% MOS and call it a day.

Others prefers historical relative valuations, they take something like P/FCF or EV/EBITDA or EV/EBIT and take the average or median as a stick ward to where the stock trade at.

Then of course we have the pure-form relative valuation folks, take your best valuation metrics P/E P/S P/B, project the denominator in the future then factor the price.

Finally we have the charts folks.

My concerns with these approaches – Please note I am not a pro in fact I do believe I know next to nothing on this topic but still my opinions:

The more break down and the more projects, the more room for error. Additionally a lot of line items often have different ways of being calculated depending on what is reported on the statements.

I tend to like this approach better. It is simpler and equal weights all possible cases. Now all possible cases might be wrong, so go figure that out.

That’s just silly. It is like adding water in salt to dilute it, just that you don’t know how much water you are actually adding.

Intuitively I feel this makes for some interesting metrics especially for stable growth companies where one doesn’t expect a huge upside. Bubble or under-price detector?

Just a shortcut/proxy to 2). The challenge is having the right forecast and the right denominator for that company.

Stock prices are a random walk in the short term.

An additional method I have started to explore more and more is the use of IRR to my NPV calculation. IRR also assumes some Net Income growth but like with 2) I usually add some bear. base, bull cases and generate a sensitivity matrix.

My conclusion: For a while I was seeking precision and ended up creating excel sheets over excel sheets. Each time I would add a new model, complex formula projections etc. and couldn’t get to a conclusion whether to invest or not. These days I tend to simplify things on the quantitative side to the following:

Does the stock have a great balance sheet?

How is it trading to historical multiple? I use EV/EBITDA and P/FCF. Is it trading lower and higher? What’s my thesis why? Do I want to own this stock despite this variance.

What’s the IRR assuming a pessimistic, base (GDP growth), bull (industry growth + GDP growth)? I generate a sensitivity matrix to establish if things go south how much loss am I looking at.

Simple DCF using FCF to Firm using an 12% discount (Risk Premium + Inflation). I use the same method for IRR regarding FCF growth.

I then look at the lowest price in the last 5 years and establish how much cash and how often and where I need to average down. I generate this in a matrix in excel. This forces me to plan future cash and plan to buy at lows if the stock gets to that point. No chickening out if the price drops.

Am I ready to own this stock for at least the next 3 years?

If all ticks, I set up a bunch of limit orders, to the price that I want and the prices I want to average down if it ever comes to it. I would revisit outstanding limit orders depending on cash available or new opportunities.

Simply put: I shifted from precision to how wrong I might be and If i am wrong what upside do I still get by buying further down.

One thing I haven’t codified yet is averaging up. I tend to not buy upward to my cost basis yet I see the pros tend to do this a lot with money influx. If someone has some hints on that, please share. Additionally I would love to hear what your quantitative approach is or how do you build conviction to your first limit order.

Disclaimer: Consult your financial professional before making any investment decision.